The Relation between Real and Accounting Earning Management

This report examines the relationship between real earnings management (REM) and accounting earnings management (AEM) with a focus on income smoothing. It explores how companies use discretionary cash flow from operations (REM) and discretionary accruals (AEM) to smooth earnings, using proxy variables to analyze income smoothing activities in Japan. The report categorizes earnings management into accounting (using GAAP like LIFO/FIFO) and real (altering investment, production, R&D, and selling/administrative expenses) approaches. It discusses the income smoothing strategy, previous research, and hypotheses regarding the interplay between REM and AEM, including the use of discretionary asset sales and R&D expenditure reductions. The research design involves models with dependent and independent variables, utilizing financial data from Japanese companies listed on the Tokyo Stock Exchange over six years. The report concludes that managers use both REM and AEM in a complementary manner, with REM potentially preceding AEM. The analysis highlights the need to control for real earnings when examining accounting earnings, while acknowledging limitations in the definitions and models used. The conclusion emphasizes the importance of careful model application.

Running Head: The Relation between the REM and AEM: Income Smoothing Perspective
Summary on THE RELATION BETWEEN REAL EARNINGS MANAGEMENT AND ACCOUNTING EARNINGS
MANAGEMENT: INCOME SMOOTHING PERSPECTIVE

The Relation between the REM and AEM: Income Smoothing Perspective 1
Summary
In the topic i.e. the relation between the real earning management and the accounting earning
management which is given by Souichi tells about the relationship between the real and
accounting earning management to smooth the earnings. The author focuses on the discretional
cash flow from operation in the case of real earning management and in the case of accounting
earning management it focuses on discretional accruals. To examine the income smoothing
activities the author uses the proxy variables of both the real as well as the accounting earning
management (Bartov, E., 1993).
The purpose of this is to find the real and accounting earning which smooth the income in Japan.
We classified the earnings management in two categories which involve accounting earning
management and real earning management. The Accounting earning includes the GAAP i.e.
generally accepted accounting principles, and this includes LIFO and FIFO method for the
valuation of the inventory. The real earning includes the real decisions related to the investment
and production as for example to reduce the R&D expenditure and the factors that are affecting
the selling and administrative expenses. These both are the important tools to manage the
earnings. After that, the author tells about the managers can use the variety of earning patterns in
which the most important pattern is the income smoothing. This is most important strategy
among all the others.
Then the author tells about the prior research and the hypothesis that it will conduct the research.
This is to be done to identify the differences between the research as well as the prior research
that is conducted. The different author gives different suggestion regarding the income
smoothing hypothesis and the ratio of debt and equity hypothesis where the author defines the

The Relation between the REM and AEM: Income Smoothing Perspective 2
discretional asset sale as the difference between the sale of a total asset and the median of the
asset of the industry. (Herrmann, D., et al., 2003).
Another author investigates some real earning management by reducing the R&D expenditure,
the cost of the sales and the expenditure occurred on the advertising by which it explains the
discretionary cash flow from operations. And on the basis of the above judgments, the author
make the hypothesis that the positive real, as well as the accounting earning management, will
observe for the firm as the negative or an unexpected income.
After that on the based on hypothesis projection, the author defines the research design in which
it includes the models where it includes the dependent as well as an independent variable which
is used in the research and the procedure of selection of sample and finally construct a model. In
the dependent variable model, it explains both the real and accounting earning management. In
the case of an independent variable, it considers the unexpected income which is the most
important dependent variable. In the sample selection, the author uses the financial data for all
the Japanese companies that are listed on Tokyo Stock Exchange. The data that is collected it
was for the six years which is used in the regression model because there is a chance of duplicity
to analysis the unexpected income so that this model is used.
After that, the author describes the model that is based on the hypothesis of both the real as well
as for accounting. First, it tells about the real earning management then the accounting because it
can't occur yet.
These model were examined that whether the real is an argument in the function of accounting or
the vice-versa. As the managers generally decide a certain level of accounting management, so

The Relation between the REM and AEM: Income Smoothing Perspective 3
they think that the accounting management earning is more argument, then the real management
earning (Matsuura, S., 2008).
At last, the author concludes that provide the result after examining all the models that manager
use real earning management or accounting earning management to smooth the earnings. Also,
they suggest that the relation between them is complementary. Also, there is evidence that the
real earning will occur before the accounting earning by which the manager firstly define the real
earning (Kothari, S., et al., 2005).
The major result based on the analysis is that real earning should be controlled when we examine
the accounting earnings. Although in this there are certain drawbacks that the author discusses as
firstly there is a different definition that is provided by different authors by which the different
model of income smoothing will construct on a different definition. Secondly, the author uses
Roy Chowdhury models for the discretional cash flow from operations for the real management
and Kothari Model for the Estimation of a discretional model for accounting earning by which
the limitation occur as these model cannot be perfectly distinguished to each other accurately.
Finally, the author comes to the point that to deal with the models more carefully it must be
necessary for them.

The Relation between the REM and AEM: Income Smoothing Perspective 4
References
Bartov, E. (1993). The timing of asset sales and earnings manipulation. The Accounting Review,
68(4), 840–855.
Matsuura, S. (2008). On the relation between real earnings management and accounting earnings
management: Income smoothing perspective. Journal of International Business Research, 7, 63.
Herrmann, D., T. Inoue, & W. B. Thomas (2003). The sale of assets to manage earnings in
Japan. Journal of Accounting Research, 41(1), 89–108.
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